Dennis' Mortgage Blog

Question of the week: Why is my APR higher than my interest rate? And what is APR? Answer:  APR stands for Annual Percentage Rate and it is derived by taking the transaction costs out of the loan amount and using the same monthly payment re-calculating for rate of interest.  It can get complicated for those not adept at math, for those adept at math it gets confusing as well.  Suppose you are borrowing $200,000 at 5% interest for a 30 year fixed rate mortgage; your monthly payment for principal and interest is roughly $1075 (okay $1073.64 exactly).  Further suppose your transaction costs for fees and points, escrow, title, etc. add up to $5,000.  To calculate your APR we keep your payment the same, roughly $1075, your loan term the same at 30 years, but instead of borrowing $200,000 we subtract the costs of $5000 and figure you are borrowing $195,000.  The rate for a roughly $1075 monthly payment for a 30 year fixed rate loan of $195,000 is 5.224%--the transaction costs equate to about one-quarter of a percent in interest rate.  APR is a useful tool when comparing apples to apples and oranges to oranges.  From lender to lender some people do not always include all the items that should be included in APR calculations—oops is the response at times when discovered.  As well I have seen Truth In Lending statements that do not include mortgage insurance in APR calculations when applicable, if there is mortgage insurance it should always be part of an APR calculation.  When comparing APRs between lenders or brokers make sure you have a copy of the Truth In Lending and Good Faith Estimate documents so you can be sure the same items are being applied to the transaction and the APR calculation.  One more aspect of APR, generally the lower your loan amount the higher the APR will be for the same loan terms.  For example I am borrowing $200,000 at 5% and 1 point and you are borrowing $500,000 at 5% and 1 point.  My APR will be higher than yours because the fixed costs associated transaction, such as the appraisal or escrow audit fees or title sub escrow fees, will be a higher percentage of my loan amount at $200,000 than your at $500,000.  Again when comparing APRs it is only an accurate comparison if all the same fees are being compared for the same loan amounts.

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We have seen a break in the linkage between the stock markets and the bond markets the past few weeks.  For most of the past year mortgage rates have followed stock prices—if stocks dropped several hundred points, mortgage rates dropped a tick or two.  If stocks rallied then mortgage rates climbed.  With the news this month of the Fed buying Fannie Mae and Freddie Mac mortgage backed securities, the Treasury finally unveiling what may be some semblance of an actual plan to relieve “toxic assets” (smelly loans?) from financial institutions, and a general feeling on Wall Street that there may actually be a stabilization of rules and guidelines and enforcement for them for the credit markets, everyone seems happy creating rising prices in stocks and bonds.

What can break the broken link?  It will not take much for us to revert to the historical relationship between stocks and bonds where rates follow the DOW.  A big one catalyst would be inflation, and it is The Big One.  There are some signs of recovery, or at least decreasing recession, in some of the economic data which points to what I was writing you in January.  We may see the bottom of the current economic cycle in the Fall or late 2009.  As you recall the $850 billion “stimulus” bill passed last month has almost no funds hitting the economy until Fall 2009, with the bulk of it not entering the economy until late 2010 and early 2011.  Combined with the Obama Administration’s $3+ trillion budget proposal that is sailing through Congressional committees and we will have over $4 trillion entering the economy in 2010.  After the bottoming out of the recession.  Add one more factor of a long period of very low interest rates for those borrowing and we find ourselves with what is known as a volatile situation.

Excess cash and really low rates are very inflationary.  There is a ton of cash in our economy right now.  Americans are saving at their highest rates in two decades.  With a reduction in cash going out for loans and balance sheets flush with TARP funds credit institutions have quite a bit of cash on hand.  The losses taken on foreclosures and short sales by mortgage holders are not losses in cash—in fact they are infusions of cash since they “spent” the funds when they made the mortgages.  Sure they are reductions in asset values on their books but they are an increase in their cash positions.  That cash gets converted when those calling the shots feel investment opportunities have reached price points that are considered bargains.  Like when the Dow Jones Industrial Average hit 6600. 

When that cash gets converted, while the economy begins its next growth cycle, while the Federal government is in the midst of a huge spending spree, inflation will be the result.   And interest rates will rise and rise fairly quickly.  Investors always trying to be at least one-tenth a step ahead (when dealing in hundreds of millions one-tenth is a pretty good margin) of everyone else, will start to bet—I mean invest—in anticipation of the markets reacting to inflation and cause rates to increase ahead of the strong inflation numbers.

What does this all mean?  It is my opinion that the very low interest rate market we find ourselves in is creating our next high interest rate market and that next market will occur sometime in the fourth quarter of 2009 or the first quarter of 2010.  Will we see a sudden jump to 8% mortgages? Probably not.  But I do foresee mortgage rates climbing above 6%, possibly up to 7% by this time next year.  For those with equity lines tied to the Prime Rate my current guess is by June 2010 the Prime Rate will be over 7% possibly 8% as the Fed tries to stem inflation.  I may be off by a quarter or two, heck I could be off totally—but looking at the data I would not bet against me.

We see the High-Balance Conforming, aka conforming-jumbo, join the conventional rates drop; but as you can see the spread is still pretty wide indicating the effects of the Fed and other investors concentrating on conventional loans.  As well the penalty on lenders for making high balance loans imposed by Fannie and Freddie are creating an artificially high rate for loans over $417,000.  FHA continues to be steady for the same reason—investor funds propping up the conventional mortgages.

FIXED RATE MORTGAGES AT COST OF 1 POINT*

30 year conventional at 1 point 4.625%                        Down 0.125%

30 year conforming-jumbo at 1 point 5.00%     Down 0.25%

30 year FHA at 1 point 5.00%                                     Flat  (3^rd week in a row)

Please note that rates quoted are based on average of several lenders for a purchase transaction with 20% down payment and a minimum FICO score of 740; APR is not quoted as it is dependent upon specific loan amounts, lenders and services selected.  Numbers provided are for comparative purposes only.

Happy Birthday Dad!  Pops turned the page on another year yesterday and it was another year where I received valuable advise and insight from him.  I remember when I was in second or third grade and him trying to teach me how to read the stock quotes in the business section, in sixth or seventh grade and him trying to teach me how to use a Hewlitt-Packard (Stanford men like him) calculator, in high school in Brussels and him trying to teach me about geo-politics and the effects on the dollar and international trade, in college and learning about using credit and creating a budget (how many months was I without any money with only one beer in the fridge?!?), in my first job at Farmers and Merchants as a teller and then in the note department him trying to teach me about patience and taking the opportunity to learn everything I could from everyone around me. I remember last summer a day spent driving several hours across Colorado to visit and old friend of his and learning the values of friendship, mentors and family.  Thanks Dad and Happy Birthday!

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Have a great weekend,

Dennis

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